What is the risk-minimizing amount of reais that the treasurer would have to buy or sell forward to hedge Madison’s peso exposure?
Madison Inc. imports olive oil from Chilean firms, and the invoices are always denominated in pesos (Ch$). It currently has a payable in the amount of Ch$250 million that it would like to hedge. Unfortunately, there are no peso futures contracts available and Madison is having difficulty arranging a peso forward contract. Its treasurer, who recently received his MBA, suggests using the Brazilian real (R) to cross-hedge the peso exposure. He recently ran the following regression of the change in the exchange rate for the peso against the change in the real exchange rate:
a. There is an active market in the forward real. To cross-hedge Madison’s peso exposure, should the treasurer buy or sell the real forward?
b. What is the risk-minimizing amount of reais that the treasurer would have to buy or sell forward to hedge Madison’s peso exposure?